The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Monday, September 9, 2013

Unfinished business in battle to fix banks...transparency

The Financial Times ran an interesting article in which it identified what it felt were the five principle reasons for bank failures ("low capital, weak funding structures, poor lending, poor trading investments and misguided mergers and acquisitions").

It concluded that 5 years after Lehman Brothers' collapse significant progress has been made using complex rules and regulatory oversight to address four of the reasons for bank failures and the fifth reason, poor lending, could not be addressed.

Left unsaid was the simple fact that transparency would successfully address all five of these reasons for bank failures.

Also left unsaid is the simple fact that it would not have taken five years to implement transparency and have each bank disclose on an ongoing basis its current global asset, liability and off-balance sheet exposure details.

In an attempt to gauge the merit of the glut of global reforms, the Financial Times has looked back at the 34 main banks and brokers that failed in the crisis, judging the principal reasons for failure from a menu of five – low capital; weak funding structures; poor lending; poor trading investments; and misguided mergers and acquisitions.

Each of these reasons is really a symptom of opacity.

For example, when banks don't have to disclose their current exposure details, they aren't subjected to market discipline to restrain their risk taking. As a result, they reduce their capital levels in lock-step to what they can convince their regulators is adequate to handle any losses they might incur.

History shows that when banks disclose their current exposure details they have a higher level of book capital. This higher level of book capital reflects both market discipline and the recognition that transparency requires a bank show it can stand on its own two feet.

Many failed for multiple reasons, though Royal Bank of Scotland is the only institution to which all five triggers applied.

Any analysis of the precise causes of the global financial crisis, even after five years of reflection, is necessarily subjective.

Please note, your humble blogger assessed and told everyone about the cause of the global financial crisis, opacity, before the crisis hit.

But if there were five main causes of failure, regulators can claim at least partial victory on four of them.

Please re-read how the regulators can claim at least partial victory on addressing for of the five main causes of failure.

This is entirely unacceptable and is a damning indictment of complex rules and regulatory oversight.

By simply using the securities laws that have existed since 1930s, all five main causes of failure could have been addressed through requiring banks to provide transparency and disclose their current exposure details.

Capital levels in the system are more than three times higher than they were before the crisis as banks pre-empt the requirements of new Basel III global standards.

Financing is more stable, with far less reliance on risky short-term market funding and new incoming rules demanding banks hold minimum levels of cash and safe assets.

Big acquisitions are a thing of the past, too, with regulators making it clear such dealmaking is unwelcome.

And the kind of complex structured investments that spread the contagion of US subprime mortgage losses around the world are close to extinct, the victim of regulators’ higher capital charges and banks’ lower risk appetites....

The one category of the FT’s five triggers of failure that is immune to regulation is bad lending – a perennial curse of banking since the Middle Ages and one that in the heat of the crisis, when the focus was on complex collateralised debt obligations, was often neglected.

“The crisis was overspun as a markets problem,” says Robert Law, a former banks analyst and adviser to the UK’s recent parliamentary commission on banking standards. “There were major problems in traditional lending, too.”

According to the FT’s analysis, this was the single biggest factor in the crisis. Of the 34 big banks that failed, three-quarters succumbed in large part because of the poor quality of basic lending – in particular to residential and commercial mortgage customers.

There is little that the authorities can do directly in a market economy to curb foolish lending practices by private sector banks.

Authorities cannot do much directly about lending as they don't want to be in the position of allocating capital throughout the economy.

As a result, bank examiners don't approve or disapprove of any exposure taken or loan made by a bank. Rather, bank examiners ask if the bank has enough capital to absorb any losses that are likely to result from the exposure or loan.

Hence, we have the following:

But reformers argue that a laser focus on capital, which can absorb losses, is the essential way to protect the system from further harm.

Unless regulators are willing to let banks take losses, something they have not done since the beginning of the financial crisis, capital is not the way to protect the system from further harm from foolish lending.

Rather, transparency is the way to protect the system from harm by foolish lending by private sector banks. Transparency protects the system in two ways.

First, transparency allows market discipline which restrains banks making foolish loans in the first place. It does this because market participants can see what loans the banks are making and can assess whether or not these loans are properly priced.

Second, transparency allows market participants to reduce their exposure to banks that make foolish loans. By reducing their exposure to what they can afford to lose should a bank that makes foolish loans go under, market participants eliminate any possibility of contagion from the bank's failure.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.